Financial stability is an objective or a subjective property of a financial system that dissipates sudden financial imbalances which appear endogenously due to significant external events or endogenously due to the impact of internal factors like inflation. The term ‘financial stability does not clearly define financial stability; instead, it depends on the inputs provided for assessing and classifying financial situations and trends. For this reason, the term may be usefully used in conjunction with other related terms and concepts.

 

As far as the concept of financial stability is concerned, the following definition may illustrate the various shades and nuances in the related concept. In the simplest terms, financial stability is the state of satisfying the credit demands of diverse financial institutions, both domestic and foreign, both in terms of volume and quality of loans. Thus, in a volatile financial system, even if domestic banks can meet credit demands, there would be a significant risk of their failure to do so. Domestic banks may still find it difficult in a highly stable financial market but not impossible to meet credit demands regularly.

 

Financial stability can be viewed from two different perspectives. On the one hand, some analysts maintain that financial stability is the ability of credit markets to operate smoothly even amidst increasing turbulence and market fluctuations. This view assumes that the existence and vibrancy of the financial markets are largely affected by the ability of financial institutions to undertake debt management and interest rate negotiations with their creditors. They argue that credit conditions are perfectly responsive to changes in domestic monetary policy, credit quality, and credit risk. Thus, even if domestic banks experience a prolonged recession accompanied by global financial difficulties, they will be able to absorb these adverse effects through appropriate credit programs and by raising interest rates progressively.

 

On the other hand, another school of thought argues that the concept of financial stability pertains to the financial system’s ability to continue operating normally despite economic and political instability. It, therefore, assumes that the existence and vibrancy of the financial systems are independent of the state of the real economy. If everything else is functioning normally, this school maintains, the existence of the real economy will not affect the performance of the financial system. On the other hand, a growing number of analysts believe that financial stability refers to a certain level of growth in the real economy against the backdrop of adverse external factors. These critics argue that credit conditions will start to deteriorate if the state of the real economy is not sound. In their opinion, even if the state of the real economy improves, the ability of financial institutions to undertake debt management and interest rate negotiations will still be impaired by the prevailing uncertainty.

 

In determining the existence and level of financial stability, some analysts consider the performance of both the domestic and the foreign economies during periods of financial volatility. For instance, during the period leading up to the Asian economic crisis, the stock market fell by more than 20 percent in some developed countries, while in developed countries, equity prices declined by more than half. The stock market was able to bounce back as the government provided financial support for the stock markets. However, financial instability does not appear to have been an accurate depiction of the condition of the real economy during that period.

 

Another measure of the health of the financial systems comes from the level of trustworthiness of the financial systems. Trustworthy financial systems can provide detailed information about the transactions in their portfolio, including the assets held by the institution and the current positions of its portfolio holdings. This type of quantitative analysis is useful for identifying the relationships between institutions and their portfolio investments. Financial stability, therefore, refers to the ability of the financial systems to provide reliable information about their holdings.

 

Another important indicator of financial stability is the existence and level of internal efficiency. The degree to which institutions possess effective internal control measures is the main determinant of the probability of financial stability. In theory, efficient internal control mechanisms would reduce external risks by allowing institutions to borrow at lower interest rates or riskier securities if they are required to do so. Financial systems that are less efficient in this regard may have higher risks and therefore have a lower probability of maintaining a high level of systemic balance.

 

One way of assessing financial stability is through the measures of institutional risk. This includes the probability of systemwide loss and the probability of institutional loss on specific portfolios. The higher the probability of systemic loss, the greater the risk of losses to other parts of the financial system. Systemic loss refers to the total losses to the entire system as a whole, even if some parts experience positive performance. Some signs of increased systemic loss include increasing credit losses as well as declines in market capitalization.